Friday, 25 November 2011 10:56

Forex Arbitrage Trading Review. A Short-Lived Trading Strategy

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Forex arbitrage trading is one of the various strategies employed by day traders on the Forex markets. The basic concept is to profit from inefficiencies in the market that are present for only a short period of time. The nature of this kind of trading is complicated, especially for the beginner, and usually requires high levels of leverage to make any serious profit.

Using arbitrage involves trading in at least 3 different currencies, and 3 different currency pair combinations that you can derive from these. First I want to mention how a currency pairing looks. The US Dollar and Euro pairing can be expressed as EUR/USD, if you buy the EUR/USD then you are buying Euros in exchange for Dollars. The first currency in the equation is always the one you are buying, the second is the one you are spending.

Forex arbitrage trading works by making three or more currency trades with the chosen currency pairings, with the final trade buying back your original currency. So, if before you placed a trade you had USD, at the end of all the trades you will again have USD. The idea is that the inefficiencies that occasionally exist will mean you end up with more USD than you started with.

Lets look at an example using the pairings EUR/USD, GBP/EUR and USD/GBP. When an inefficiency in the markets is identified, it gives us an opportunity to buy EUR with USD, then buy GBP with EUR and then buy back our original USD with GBP and finish up with more than we started. These inefficiencies do exist in the markets everyday, but are only available for a short time.

We will assume the following buying exchange rates for our example:

EUR/USD: 1.533272 (For one Euro you will get 1.533272 Dollars)
GBP/EUR: 1.3127 (For one Pound you will get 1.3127 Euros)
USD/GBP: 0.4967956 (For one Dollar you will get 0.4967956 Pounds)

Now let’s go through each trade in our example. We will begin with $500,000 and buy Euros: 500,000 / 1.533272 = 326,100 Euros. We take these Euros and by Pounds: 326100 / 1.3127 = £248419.28. Lastly we take our pounds and buy back the Dollar: 248419.28 / 0.4967956 = $500043.23. So we have made a profit of $43.23.

When one of these opportunities to profit from the discrepancies between currencies arises, it is vital that an arbitrage trader executes their trades swiftly. With thousands of traders the world over waiting for one of these windows of opportunity to come about, the time it takes for the markets to correct themselves due to these traders placing their currency orders is short. The act of participating in Forex arbitrage trading actually contributes to the short-lived nature of the opportunity, with the market quickly responding to thousands of traders placing the same orders.

You may be wondering then, how do traders actually identify these opportunities, given that the time frame they are available is so short and the calculations many and intricate. Can you imagine a trader staring at a chart of exchange rates frantically tapping into his calculator trying to find such an opportunity? Not really! Forex arbitrage trading is made possible by the use of software that can analyse the markets and immediately inform the trader of an opportunity.

Such software is often provided by brokers, or can be bought independently and downloaded. There are also versions which run straight of the internet some of which are free. The important thing to remember is that in order to be able to take part in arbitrage trading, it is vital that you have a live feed of exchange rates and a solid reliable internet connection.

As you can see it took 3 trades to make just $43.23 profit, and this strategy is by no means limited to just 3 trades. Any number of trades can be involved, using any number of currency pairs. In order to make serious money with Forex arbitrage trading, you will need either a healthy trading balance or be willing to leverage your account very heavily.

For the most part, forex arbitrage trading will generally only be a small part of an experienced traders dealings. For the inexperienced trader, arbitrage trading is not an ideal trading model to start with, and nor is it the best option to make a sustainable income from trading the Forex markets.

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